Selling with Owner Financing
Let’s kill two birds with one loan!
– Goodman Ace
The sale of a real estate investment involves the weighing of a variety of critical factors that determine whether and how much of a profit may be made. Finding a buyer with the requisite credit and financial situation to execute a purchase that provides a profit for the seller is no easy feat. Tightened credit and underwriting requirements serve to reduce the number of potential buyers. In addition, the economic climate, fluctuating interest rates, and rapidly changing tax laws cause economic uncertainty for investors.
Property owners who have significant equity in their property or who have paid off their property entirely have greater flexibility and potential for profit and cash flow. Selling with owner financing, also known as “seller financing,” is an alternative lending option through which a seller finances a property–essentially filling the role of both seller and mortgage lender. Property owners who utilize this strategy often have greater negotiating power and, as a result, more frequently sell their property for their asking price. Property owners who finance their purchasers often earn better rates of return than other investments such as dividend-paying equity, bonds, or even direct real estate investments. By selling with owner financing, property owners convert their real estate from a direct and active investment to an indirect and passive one, essentially disposing of the responsibilities and liability of direct property ownership while simultaneously gaining an income stream secured by the property itself.
wHAT IS OWNER FINANCING?
Owner financing is a broad term that encompasses a variety of strategies designed to convey title to real property through the seller’s financing of all or some of the purchase price.
When property owners sell residential, commercial, industrial, or specialty property using owner financing, they assume the lender’s role and become “the bank.” The buyer finances the purchase through the seller instead of a conventional bank or mortgage lender. Just as a bank or mortgage lender would, the seller extends credit to the buyer at closing to cover the property’s purchase price, less the buyer’s down payment, and then the buyer makes regular payments to the seller until the loan amount is paid in full.
- Owner financing can be structured as a short-term or long-term mortgage with terms and rates being negotiable.
- Just like a traditional mortgage, the buyer signs a promissory note which outlines the loan terms including the repayment schedule, interest rate, and what should happen in the event of a payment default.
- Unlike a traditional mortgage, the exchange for the full purchase price of the property does not need to change hands.
- Owner financing provides an excellent option for a property owner or real estate investor ready to step back from property ownership but who still seeks consistent monthly cash flow
BENEFITS OF SELLING WITH OWNER FINANCING
Selling a property with owner financing affords the following benefits:
- Reduced time-on-market: Owner financing provides more opportunity to buyers who, while qualified to own property, cannot qualify for a traditional bank loan.
- Top-dollar offers: Buyers who obtain financing through sellers are more willing to pay at or above market price.
- Can sell “as is”: Owner financing affords sellers the opportunity to sell their property without making costly repairs that would be mandatory with traditional lenders and sell property that otherwise wouldn’t qualify for traditional financing.
- Faster sale: Seller financing puts all of the mortgage processes in the hands of the seller, enabling a seller to close on a transaction at their own pace–often much faster than traditional financing.
- Higher interest rates: In addition to the purchase price, sellers earn interest rates that, in most cases, are higher than rates available through other types of investments.
- Tax planning: Since the total purchase price is paid over time rather than all at once, any applicable taxes on realized gains on the sale may be spread out over the term of the loan.
- Reduced ownership responsibilities: Selling with owner financing transfers property-specific obligations and liabilities such as property tax, insurance, premises liability, and maintenance to the buyer.
- Monthly income: Sellers who finance buyers are poised to receive a steady monthly income stream over a period secured by a mortgage on the property.
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TYPES OF OWNER FINANCE AGREEMENTS
The buyer receives all rights of ownership, and, depending on whether the jurisdiction follows Lien Theory or Title Theory, the buyer may also receive legal title to the property. Simultaneously, the seller holds a lien and thus an interest in the property. The mortgage note specifies payment terms including the purchase price, term, interest, and other conditions attached to the loan.
Deed of Trust
The title is held by a trustee who holds it as a security for the seller until the loan is repaid in full. This is not required in all states but can be used in all states.
The buyer pays a down payment and subsequent regular installments until the balance of purchase price and interest is paid in full. This is an alternative to a mortgage but is disfavored by buyers as it sidesteps the usual protections provided in a mortgage.
TYPES OF OWNER FINANCING
TRADITIONAL SELLER FINANCING (SELLER-HELD FINANCING)
With traditional seller-held financing, the buyer and seller agree on a purchase price, an annual interest rate, and loan terms. This method typically only involves the two parties: the seller and the buyer. There exists only one mortgage on the property for the remaining balance to be repaid by the buyer. Terms between the party are limited only by general financing and mortgage laws like usury rates. Thus, seller-held financing allows for both short-term and long-term payment plans.
SHORT-TERM SELLER FINANCING
Short-term owner financing is becoming more popular as credit requirements tighten, forcing buyers to seek alternative financing. This strategy is the same as seller-held financing except that the term of the loan is dramatically shorter; rather than a 25 to 30-year amortization and term, short-term owner financing typically involves a 25 to 30-year amortization and a 5 to 10-year term. At the end of the term, the balance owing is due. This is called the “balloon” payment.
The buyer who agrees to a short-term owner finance contract intends to either rapidly pay off the contract before the end of the term, acquire traditional or alternative financing before the end of the term, or pay cash at the end of the term for the remaining balloon payment. This strategy is a bit riskier than a traditional seller-held financing contract for both the seller and buyer. There is no guarantee that by the end of the contract term the buyer will be able to cover the balloon payment. If he does not, the seller will have to either extend the term of the financing, create a new financing contract, or pursue foreclosure due to breach of the mortgage contract. During this time, however, the seller typically has i) received a down payment; ii) received monthly principal payments; and iii) received monthly interest payments. Hopefully, over the 5 to 10-year term the property’s equity will have grown, and recovering the remaining balance will be simple.
OTHER TYPES OF OWNER FINANCING OPTIONS
JUNIOR MORTGAGE (WRAP AROUND)
Most lenders are reluctant to finance more than 80% of a property’s value in today’s market. In a junior mortgage, a seller extends credit to the buyer to make up the difference through a second or “junior” mortgage for the balance of purchase price, less the down payment. In this method, the first mortgage lender transfers the proceeds from the buyer’s first mortgage to the seller. Another wrap around strategy involves a borrower assuming one or more of the seller’s existing mortgages while the seller finances the difference between balances owed and the purchase price, less the down payment.
For example, the purchase price of a property is $1,000,000, and the buyer has found a lender who will finance up to $800,000 of the purchase price. The buyer has $125,000 to put down, so the remaining balance would be $75,000. The seller in this case may finance the remaining $75,000 as a second, junior mortgage on the property and walk away with $925,000 less closing costs plus monthly payments on the $75,000 loan. However, because of the lower priority security interest in the property, if the buyer defaults on the first mortgage and the lender forecloses, the seller will only be entitled to recover the difference between the foreclosure sale price and the balance owed to the first mortgage holder up to the remaining balance. Therefore, this method is more common in higher dollar figure transactions to bridge this type of gap.
A lease-purchase option works much like an ordinary rental, where the seller leases the property to a buyer for an agreed period. The difference is that in return for receiving an upfront, non-refundable fee, the seller agrees to sell the property at some future specified time at terms agreed. The non-refundable fee acts as a paid option contract and locks in the buyer’s ability to purchase the property if the landlord has a change of heart.
Virtually all lease-purchase terms are negotiable, and a wide array of variations exist. For example, the terms may or may not include a set price and instead use a formula based on a consumer index or appraisal figure. However, lease-purchase options are typically structured so that at least some of the rental payments are credited against the purchase price. The lease agreement also sets the down payment amount and schedule of payments.
The lease agreement option provides a seller with the following advantages:
- Lock in a reasonable price for the property in advance.
- Attracts responsible tenants seeking long-term tenancy.
- Tenants are more likely to protect the investment, maintain and improve the property.
- Conditions such as the requirement for on-time rental payments can be used to qualify borrowers.